Corporate Bonds Can Offer a Steady Return
Once the mainstay of fixed-income investments, these bonds are less popular but still worthy
HOW times change! To many financial analysts, the corporate bond market has become the wallflower of the financial world - holding a dance card that fewer and fewer individual investors want to sign.
Yet, from colonial days right through the first half of this century, the opposite was true. Investing back then usually meant either buying ''stocks'' or ''bonds,'' and ''bonds'' were largely corporate bonds - fixed instruments with maturities usually ranging from five to 20 years issued by companies. Today, however, the corporate bond market pales in popularity alongside competing fixed-income markets, such as United States Treasury issues and municipal bonds issued by state and local governments.
Why the shift?
The reasons for the shift in sentiment are numerous, experts say.
Corporate bonds have become overshadowed by the higher returns offered by competing products. Interest on corporate bonds is fully taxable, unlike interest earnings on US Treasury issues, which are exempt from state and local taxes, or municipal bonds, where interest is exempt from federal taxes and some state taxes. Buying corporate issues through a broker usually requires paying a broker's fee; Treasury bonds have no commission charges if you buy them directly from Uncle Sam.
And corporate issues have gotten some unhappy press in recent years, as many companies have yanked the rug out from under bondholders, either by ''calling'' in their bonds - that is, redeeming the bonds before their final maturity date - or simply going out of business, leaving bondholders high and dry. Further, credit ratings on a number of corporate securities have occasionally been reduced, lowering the market value of the bond in the resale market.
Through Aug. 28, US corporations have issued some $93 billion worth of bonds during 1995, up slightly from $87 billion issued in the same period last year, says Aricka Martinez, a bond specialist with Standard & Poor's Corp., a financial-services firm in New York.
Many corporate bonds are sold to tax-deferred pension plans, rather than individual investors. The greater popularity of noncorporate issues for small investors can be quickly seen by looking at mutual-fund holdings - where most individual investors tend to park their bond money. As of June, there were roughly 102 corporate bond funds, with assets of around $29 billion. There were also 98 high yield (that is, junk corporate bond) funds, with assets of $53 billion. By contrast, there were about 1,022 municipal bond funds, with assets of more than $240 billion
Why then buy a corporate bond? According to most experts, to gain a steady return of income at (presumably) a good interest rate from a well-established US company. There are three primary ways to buy corporate bonds: individually, through a broker; by buying mutual funds; or buying into a unit investment trust (UIT), which are packages of bonds sold through brokers.
In buying a corporate bond, or buying into a bond fund, the key factors, says Mark Wright, a bond expert with Chicago-based investment firm Morningstar Inc., are interest rates (what the bond pays in terms of yield); duration (how long the bond must be held to receive its stated yield no matter what happens to interest rates); and quality (its ''investment grade,'' which is based on an assessment of the company's ability to pay off bondholders.)
Most experts stress that individuals should look for top-grade bonds, bonds with a Triple A (AAA) rating from an established rating service such as Standard & Poor's or Moody's. Return will not be as great as would be paid on a high-yield (junk) bond. But the quality ensures a greater likelihood that the bond will meet payment schedules. Corporate bond mutual funds are considered safest, since they provide far greater diversification than buying individual bonds.
Yields on corporate issues, by definition, are higher than for US Treasury issues. But that's because of their greater risk.
Morningstar follows some 77 corporate-grade bond funds, and another 44 high-yield funds (junk bond funds). Ironically, the high-yield funds tend to snap up a larger number of ''stars,'' that is, top performance rankings issued by Morningstar, than do corporate bonds. The reason: junk bonds pay higher yields and are less sensitive to interest-rate fluctuations, says Wright. Thus, last year, he notes, many junk-bond funds did very well, while most bond funds were heading south in terms of total return. The drawback, of course, is that junk-bonds can be very risky.
To determine whether your corporate bond is a good investment, you might need to compare what you would earn on a competing tax-free bond, such as a municipal bond. Take the example of a municipal bond (where interest earnings are exempt from federal taxes) paying 5 percent, vs. a corporate bond (where earnings are taxed) paying 6 percent. Divide the municipal bond by 1 minus your tax rate, such as 28 percent. Thus, you would divide 5 percent by 0.72. That works out to 6.94 percent.
Bottom line: your corporate bond would have to provide a yield of 6.94 percent to equal the yield on the muni bond if you are in the 28 percent tax bracket. In this case, it doesn't; so on a yield comparison, the muni does slightly better.
Still, corporate bonds are attractive to many conservative investors looking for a steady income stream. UITs represent an innovative way to buy into a corporate-bond package by obtaining consistent returns combined with a degree of diversification and preservation of principal, says Joseph Lizzio, vice president of investments with Dean Witter Reynolds Inc., in Garden City, NY. Unit trusts, which can be purchased through brokers, start as low as $1,000.
Commission charges run 4 percent to 4.5 percent - comparable to charges on a load mutual fund, but higher than for a no-load fund.
When you buy bonds, the key factors are interest rates, duration to yield, and quality, or 'investment grade.'